Two Posts Worth Reading

by Geoff Gannon

Here are two posts worth reading.

One is about the outperformance of \"glamor\" over \"value\" stocks these last few years. I've felt this. On a relative basis, the last couple years have been the hardest time ever for me to pick stocks. 

Value Badly Lagging Glamour

The other post is about Sanborn Map. It's a classic Buffett investment. And the post does a good job of breaking down the logical arguments that were probably running through Buffett's head.  

Some Thoughts on Sanborn Maps

 

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Here are two posts worth reading.

One is about the outperformance of "glamor" over "value" stocks these last few years. I've felt this. On a relative basis, the last couple years have been the hardest time ever for me to pick stocks. 

Value Badly Lagging Glamour

The other post is about Sanborn Map. It's a classic Buffett investment. And the post does a good job of breaking down the logical arguments that were probably running through Buffett's head.  

Some Thoughts on Sanborn Maps

 

Discussion off

Armanino Foods of Distinction (AMNF)

by Geoff Gannon

\u200BA few people have emailed me asking for my thoughts about Armanino Foods of Distinction (AMNF). I don't have any right now. But Whopper Investments does:
I think Armanino is undervalued at today\u2019s prices. It\u2019s growing pretty fast and creating tons of value from that growth, so that value gap should (hopefully) grow over time. And, as an added kicker, there\u2019s the potential for a merger at a huge premium, which would be easily supported by the synergy potential, and/or a big special dividend to lever the company up.\u200B

I lied. I do have one thought. At one point, Whopper says:

\u200BI tend to think that their frozen products fall more into the \u201Ccommodity\u201D segment than the \u201Cbranded\u201D segment, but their returns on capital actually suggest other wise. Pre-tax returns on capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to indicate some form of brand strength or competitive advantage.

That's true. However, it is imperative that when you find empirical evidence of a competitive advantage you back it up with a rational explanation for that competitive advantage.

You always want to combine abstract reason with concrete evidence to prove something's practical existence. \u200B

If you fail to do this, you will end up taking the magic formula approach. Many companies earn excess returns. Some have durable moats. Others do not. It may work out on average to simply assume moats based on high returns on capital. \u200BIn fact, the historical data Greenblatt used says that the approach did work in the past.

But you must never beg the question. You must never argue that this company has a moat because only a company with a moat could earn the returns this company is now earning.

Instead we must look for both a rational theory and empirical data that are reasonable when considered separately and agree when put together. \u200B

\u200BArticles

Is Quality as Good as Growth?\u200B

Where Does a Stock's Future Return Come From?

Should Buy and Hold Investors Worry about EV/EBITDA?\u200B

How Today's Debt Lowers Tomorrow's Returns

Why I'm Pessimistic about Stocks

\u200B

Talk to Geoff

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A few people have emailed me asking for my thoughts about Armanino Foods of Distinction (AMNF). I don't have any right now. But Whopper Investments does:

I think Armanino is undervalued at today’s prices. It’s growing pretty fast and creating tons of value from that growth, so that value gap should (hopefully) grow over time. And, as an added kicker, there’s the potential for a merger at a huge premium, which would be easily supported by the synergy potential, and/or a big special dividend to lever the company up.

I lied. I do have one thought. At one point, Whopper says:

I tend to think that their frozen products fall more into the “commodity” segment than the “branded” segment, but their returns on capital actually suggest other wise. Pre-tax returns on capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to indicate some form of brand strength or competitive advantage.

That's true. However, it is imperative that when you find empirical evidence of a competitive advantage you back it up with a rational explanation for that competitive advantage.

You always want to combine abstract reason with concrete evidence to prove something's practical existence.

If you fail to do this, you will end up taking the magic formula approach. Many companies earn excess returns. Some have durable moats. Others do not. It may work out on average to simply assume moats based on high returns on capital. In fact, the historical data Greenblatt used says that the approach did work in the past.

But you must never beg the question. You must never argue that this company has a moat because only a company with a moat could earn the returns this company is now earning.

Instead we must look for both a rational theory and empirical data that are reasonable when considered separately and agree when put together.

Articles

Is Quality as Good as Growth?

Where Does a Stock's Future Return Come From?

Should Buy and Hold Investors Worry about EV/EBITDA?

How Today's Debt Lowers Tomorrow's Returns

Why I'm Pessimistic about Stocks

Discussion off

How to Read a 10-K

by Geoff Gannon

A blog I read, valueprax, reviewed How to Read a Book. I had never read the book before. So I thought I would give it a try. It is – of course – mostly about reading books. And while investors read a lot (in fact, that’s most of what they do) it rarely comes in book form.

Still, a lot of what you’ll find in can help with reading 10-Ks, S-1s, investor presentations, earnings call transcripts, annual letters, newspaper articles, trade journals, etc.

I think this quote sums up the problem new investors have:

Most of us are addicted to non-active reading. The outstanding fault of the non-active or undemanding reader is his inattention to words, and his consequent failure to come to terms with the author.

SEC reports are not known for being communicative. But in most cases where someone emails me asking about a part of a 10-K they do not understand – the answer can be found in the same 10-K. You just have to read the footnotes, understand how the income statement and cash flow statement and balance sheet relate, and know whether the company is using GAAP or IFRS. With the internet, you don’t even need to know all the actual norms of GAAP and IFRS – since you can always just google “IFRS biological assets” if you’re confused.

This sounds like a lot to keep straight. But if you come to every 10-K armed with a pen, a pad of paper, a highlighter, and a calculator – it’s so much easier. When I see something out of the ordinary I just scrawl “Depreciating too fast?”, “Why did marketing expense double?”, “When was building bought?”, etc. right in the margin.

It is easy to miss the relevance of depreciation method, useful life, residual value, etc. in a depreciation footnote if you read it the way you would read a newspaper article, novel, etc. Most people read most things passively.

Read the 10-K actively.

A depreciation footnote takes on a whole new meaning when you are looking through the 10-K specifically making calculations based on questions you came up with yourself about depreciation. You now read it in the context that matters to you.

Here’s one other great piece of advice from . Just read the whole thing straight through first. It’s amazing how few people read a 10-K twice. If you’ve ever seen a movie straight through twice – within the same week or so – you’ll realize you missed a lot the first time through. Popular movies are not made to be dense or difficult to understand. But I don’t think there’s anyone who can see even a very superficial seeming movie twice in the same week and not find something in the rewatch they missed the first time through.

Why?

Context. The best context in which to analyze something is to already be familiar with it. The first time you see something you’re seeing it. The second time you see something you’re analyzing it.

If you feel like you’re not getting enough out of 10-Ks, try to read a 10-K a day. And try to read it twice. Read it once without worrying about whether you understand it. Then read it the second time with you pen and paper and highlighter and calculator.

You will always find something you missed the first time.

And yes, it’s much easier to read your 100th 10-K than your first 10-K. They are a genre. It’s a pretty dry genre. But it’s still a genre. And you’ll be pretty genre savvy by the time you reach your hundred and first 10-K.

 

Discussion off

Hint: Read the Oldest 10-K

by Geoff Gannon

I recently mentioned something in an email that I'm not sure I've said before on this blog. I always read the newest and oldest 10-K for a company when I start analyzing it. Reading the oldest 10-K gives you perspective.

\u200BThis little habit will make you a better investor.

EDGAR has 10-Ks going back to the mid 1990s. So, you'll have the experience of reading a 2012 annual report and something like a 1996 annual report. \u200B

This always gives me added perspective on the business. And it gets my thinking about how the business has changed over time and how it will change in the future. \u200B

Talk to Geoff

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I recently mentioned something in an email that I'm not sure I've said before on this blog. I always read the newest and oldest 10-K for a company when I start analyzing it. Reading the oldest 10-K gives you perspective.

This little habit will make you a better investor.

EDGAR has 10-Ks going back to the mid 1990s. So, you'll have the experience of reading a 2012 annual report and something like a 1996 annual report.

This always gives me added perspective on the business. And it gets my thinking about how the business has changed over time and how it will change in the future.

Discussion off

News: George Risk (RSKIA) and Ark Restaurants (ARKR)

by Geoff Gannon

I only own two American stocks. Both are micro caps. They are George Risk (RSKIA) and Ark Restaurants (ARKR). Both stocks came out with news recently.

Ken Risk, the CEO and majority (58%) owner of George Risk, died. His daughter, already the CFO, was made President and Chairman. His widow was also added to the board.  The company's record under Ken Risk was extraordinary. His death is a big negative for shareholders.

Ark Restaurants rejected a $22 a share buyout offer from Landry's. Then Landry's sent out a press release questioning the motives of Ark's board. \u200B

Here are the latest press releases in each story:\u200B

\u200BGeorge Risk 8-K

Landry's Press Release

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I only own two American stocks. Both are micro caps. They are George Risk (RSKIA) and Ark Restaurants (ARKR). Both stocks came out with news recently.

Ken Risk, the CEO and majority (58%) owner of George Risk, died. His daughter, already the CFO, was made President and Chairman. His widow was also added to the board.  The company's record under Ken Risk was extraordinary. His death is a big negative for shareholders.

Ark Restaurants rejected a $22 a share buyout offer from Landry's. Then Landry's sent out a press release questioning the motives of Ark's board.

Here are the latest press releases in each story:

George Risk 8-K

Landry's Press Release

Discussion off

Charlie Munger’s 3 Places to Find Stocks

by Geoff Gannon

Market Folly links to an interview Mohnish Pabrai gave to The Motely Fool. In that interview, Pabrai mentions 3 places Charlie Munger said you should look for stocks. Munger said to look for stocks that:

1.    Great investors are buying

2.    Are reducing their share count

3.    Are being spun-off

For #1 you can read the Market Folly blog, go to GuruFocus, or subscribe to the Hedge Fund Wisdom Newsletter.

For #2 you can read Value Line, go to GuruFocus, or go to Morningstar.

And for #3 you can go someplace like StockSpinoffs.com.

Discussion off

New York Stock Exchange Sold: Urbana Cheap

by Geoff Gannon

Whopper Investments has a post discussing what the sale of the New York Stock Exchange means for the Canadian closed end fund Urbana.

A lot of value bloggers have a problem with the management of Urbana. I don’t. But I do have a problem with the price of the portfolio that will be left after this merger. If you look at the stocks that make up the bulk of Urbana’s portfolio – which will be CBOE (CBOE) and some amount of Intercontinental Exchange (ICE) – these are pricey stocks.

Still, Urbana’s discount to net asset value was recently about 50%. It is a stock worth watching because the discount to NAV is often big and the portfolio is easy to understand. But the underlying assets are not something I’m interested in.

My favorite holding companies to invest in are situations where I like the underlying assets and think they are reasonably priced and then I get a discount to NAV. At Urbana, I think the discount to NAV is the only attraction.

But if you want to invest in securities exchanges, Urbana is the place to start.

Discussion off

Japanese Net-Nets: Noda Screen Management Buyout

by Geoff Gannon

Some readers emailed me about the fact that a company from my list of 15 Japanese net-nets I put out in a 2011 report is going private. The company is Noda Screen. It is up 124% in the last year. But only 32% since my “Buy Japan” post in March of 2011. Another company from the net-net list, Sanjo Machine Works, was taken private about a year ago.

For details on how Japanese net-nets performed from early 2011 through early 2012 see the post “How About Those Japanese Net-Nets” at Oddball Stocks.

Discussion off

Oddball Stocks Posts 13 Stocks for 2013

by Geoff Gannon

Nate over at Oddball Stocks put up . This is a good list of obscure stocks from around the world. They are all worth looking into.

Discussion off

John Malone Interview

by Geoff Gannon

Mr. Market blog links to an excellent John Malone interview. It is definitely worth watching the whole thing. By the way, if you don’t know anything about John Malone the book is a good place to start.

Discussion off

My Investment Process

by Quan Hoang

Someone who reads the blog sent\nme this email:\n\n

Quan,
What is your process for reviewing an idea?  What do you\nmake sure to read? (documents, news, history of business, industry report, etc?)\n I was impressed by your discussion of CCL, and thought that many of\nthe details you had included weren't readily available in a 10-k or company\ndocument.  How and where do you go to get that type of data (thing like\nunit economics, for example)?
Many thanks,
Mostafa

I used to have a fear that I can\u2019t find enough\ninformation to analyze a company. I don\u2019t remember when that fear went away. But\nthat\u2019s not because I got more information. That\u2019s because my process improved.

One problem I see in a lot of books is the hammer bias. To\na man with a hammer, every problem looks like a nail. I think authors usually\nstart a project with some hypotheses and they look at data and information from\nthat point of view. They give examples and explain by their thesis. But things\nare usually results of many reasons.

Ten\nPoints to Look at

We can easily fix that problem. As Charlie Munger\nsuggests, the cure is to equip the man with as many tools as possible. My tools\nare my investment checklist. I have 10 questions to answer in my research:

-      Competitive\nPosition

-      Product\nEconomics

-      Return\non Capital

-      Management

-      Organization

-      Capital\nAllocation

-      Repeatability

-      Future\nProspects

-      Safety

-      Understanding

And I have a sub-checklist for each item in the\nchecklist.

Twelve\nBooks to Start

My checklist was initially based on ideas from the books\nI read. If I started over studying value investing today, I would read these books:

-      Security\nAnalysis by Ben Graham

-      Common\nStocks and Uncommon Profits and Other Writings by Phil Fisher

-      The\nLittle Book that Builds Wealth by Pat Dorsey

-      Profit\nfrom the Core by Chris\nZook

-      Beyond\nthe Core by Chris Zook

-      Unstoppable by Chris Zook

-      Repeatability by Chris Zook

-      Talent\nis Overrated by Geoff\nColvin

-      Built\nto Last by Jim Collins

-      Good\nto Great by Jim Collins

-      How\nthe Mighty Fall by Jim\nCollins

-      Great\nby Choice by Jim Collins

Security Analysis and Common Stock and Uncommon Profits\nare the best investment books I\u2019ve read. The former gives us a complete\nunderstanding of value of a company. The latter shows us important aspects of a\ncompany to analyze.

The Little Book that Builds Wealth is a good introduction\nto moat. There\u2019s a lot of interesting examples. But there\u2019s a weakness. Pat\nDorsey underrates the role of management. He looks at a moat in static terms. I\nthink we should look at a moat in dynamic terms. That\u2019s why I think it\u2019s\nimportant to read Chris Zook\u2019s books.

Chris Zook\u2019s books are about repeatability. The idea is\nto utilize organizational capabilities to adapt to changes in the market or to repeat\nsuccess in growth opportunities like a new customer segment, a new geographic\nmarkets, or adjacent products.

I find that Talent is Overrated is a good addition to\nChris Zook\u2019s book. Great performers are those who repeat practicing in learning\nzone. That also applies to business. Companies that repeat sharpening their key\ncapabilities will widen their edge over competitors.

I think investors undervalue Jim Collins\u2019 books. He broke\nsome myths about management. I think the books show how to build a great\norganization. It\u2019s helpful for investors to judge management.

Improve\nMy Checklist from Real-life Observation

But more important is practice. Each company is a real example.\nAnalyzing each company helps me realize what\u2019s important to each checklist\nquestion. And I just keep updating my sub-checklist. My process improves after\neach research.

For example, I didn\u2019t have a clear idea about how to\njudge an organization. But overtime, I realized unionization and internal\npromotion are something to look at. It\u2019s helpful to see if the organization is\nsales-driven or research-driven or operation-driven. The distance from front\nline employees to CEO and the company location are also useful.

Reading interviews, earnings call transcripts and compare\nwhat the management said with results also make me better at judging people. I\ncan easily find that Royal Caribbean\u2019s management is quite promotional. Carnival\u2019s\nMicky Arison is honest and blunt. Or Western Union\u2019s management is competent\nbut overly optimistic.

Practice also improves my understanding of moat, even\nthough it\u2019s a topic that economists and investors pay a lot of attention to. For\nexample, I think customer behavior doesn\u2019t get as much discussion as it deserves.\nPerhaps that\u2019s because it isn\u2019t easy to describe customer behavior in a formula\nlike economies of scale or network effects. Many times, customer behavior is explained\nby psychology. Again, a checklist is a powerful tool.

For example, looking at frequency and purchase price is\nhelpful. High frequency with low purchase price is good. Customers are rational\nonly when they first choose a product. Once they are satisfied with their\nchoice, they\u2019ll be loyal. They don\u2019t want to think and choose every time they\nbuy the product. They rely on habit instead. That\u2019s why consumer products are\nsuch a good business.

Low frequency with high purchase price is bad. Customers\nare rational. They spend a lot of time to compare alternatives. That\u2019s why I\nthink selling to business customers is difficult. That\u2019s why I don\u2019t like\nconsumer electronics companies.

Low frequency makes auto part retailers like AutoZone (AZO) a good business. Customers\ndon\u2019t buy often so they don\u2019t know much about price. Auto part retailers don\u2019t\ncompete on price. They compete on service instead. AutoZone focuses on \u201CYes\nrate\u201D.  AutoZone doesn\u2019t want to say No\nto customers. It wants customers to know that AutoZone will solve their\nproblems. So, frequency is low but the awareness is high.

On the contrary, low frequency makes fine dining\nrestaurants like Ark Restaurants (ARKR)\na difficult business. Customers go to these restaurants on special occasions. There\nmight be a lot of planning. Customers may not be loyal. But once the service is\nbad, customers will never come back. So, despite the crisis and rising food\ncost, Ark couldn\u2019t reduce payroll. They must maintain good service.

Among my 10 points, I didn\u2019t find much discussion about\nproduct economics in books. But it\u2019s very important. Strong competitive\nposition with bad product economics is bad. Railroads has strong moat but bad\nproduct economics. They earn only an adequate return on investment.

So, it\u2019s important to see whether costs are fixed or\nvariable; whether the business requires a lot of capital investment; whether\ngrowth requires much capital; whether the product cycle is long or short; or\nwhether cash collection is faster than cash payment; etc. The list of questions\njust keeps expanding as I gain more experience.

I\nDidn\u2019t Get More Information, My Eyes Just Get Keener

As I mentioned above, the information I look at didn\u2019t\nchange. I read all conventional sources. I read 10-Ks, transcripts, and\ninterviews. I try to read all books about a company. I read all articles I can\nfind about a company. I read from the oldest to the most recent article. That\nhelps me see how the company evolved over time.

I do the same thing to customers and competitors. So, it\u2019s\na good idea to analyze end-customer and go up the value chain.

I look at data and information with my checklist (and\nsub-checklist) in mind. I make notes or do calculation with data whenever I see\nsomething relevant. I update my checklist after each research. And I\u2019ll reduce\nthe amount of important information I miss in later research.

Talk to Quan about his Investment Process

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Someone who reads the blog sent me this :

Quan,
What is your process for reviewing an idea?  What do you make sure to read? (documents, news, history of business, industry report, etc?)  I was impressed by your discussion of CCL, and thought that many of the details you had included weren't readily available in a 10-k or company document.  How and where do you go to get that type of data (thing like unit economics, for example)?
Many thanks,
Mostafa

I used to have a fear that I can’t find enough information to analyze a company. I don’t remember when that fear went away. But that’s not because I got more information. That’s because my process improved.

One problem I see in a lot of books is the hammer bias. To a man with a hammer, every problem looks like a nail. I think authors usually start a project with some hypotheses and they look at data and information from that point of view. They give examples and explain by their thesis. But things are usually results of many reasons.

Ten Points to Look at

We can easily fix that problem. As Charlie Munger suggests, the cure is to equip the man with as many tools as possible. My tools are my investment checklist. I have 10 questions to answer in my research:

-      Competitive Position

-      Product Economics

-      Return on Capital

-      Management

-      Organization

-      Capital Allocation

-      Repeatability

-      Future Prospects

-      Safety

-      Understanding

And I have a sub-checklist for each item in the checklist.

Twelve Books to Start

My checklist was initially based on ideas from the books I read. If I started over studying value investing today, I would read these books:

-      by Ben Graham

-      by Phil Fisher

-      by Pat Dorsey

-      by Chris Zook

-      by Chris Zook

-      by Chris Zook

-      by Chris Zook

-      by Geoff Colvin

-      by Jim Collins

-      by Jim Collins

-      by Jim Collins

-      by Jim Collins

Security Analysis and Common Stock and Uncommon Profits are the best investment books I’ve read. The former gives us a complete understanding of value of a company. The latter shows us important aspects of a company to analyze.

The Little Book that Builds Wealth is a good introduction to moat. There’s a lot of interesting examples. But there’s a weakness. Pat Dorsey underrates the role of management. He looks at a moat in static terms. I think we should look at a moat in dynamic terms. That’s why I think it’s important to read Chris Zook’s books.

Chris Zook’s books are about repeatability. The idea is to utilize organizational capabilities to adapt to changes in the market or to repeat success in growth opportunities like a new customer segment, a new geographic markets, or adjacent products.

I find that Talent is Overrated is a good addition to Chris Zook’s book. Great performers are those who repeat practicing in learning zone. That also applies to business. Companies that repeat sharpening their key capabilities will widen their edge over competitors.

I think investors undervalue Jim Collins’ books. He broke some myths about management. I think the books show how to build a great organization. It’s helpful for investors to judge management.

Improve My Checklist from Real-life Observation

But more important is practice. Each company is a real example. Analyzing each company helps me realize what’s important to each checklist question. And I just keep updating my sub-checklist. My process improves after each research.

For example, I didn’t have a clear idea about how to judge an organization. But overtime, I realized unionization and internal promotion are something to look at. It’s helpful to see if the organization is sales-driven or research-driven or operation-driven. The distance from front line employees to CEO and the company location are also useful.

Reading interviews, earnings call transcripts and compare what the management said with results also make me better at judging people. I can easily find that Royal Caribbean’s management is quite promotional. Carnival’s Micky Arison is honest and blunt. Or Western Union’s management is competent but overly optimistic.

Practice also improves my understanding of moat, even though it’s a topic that economists and investors pay a lot of attention to. For example, I think customer behavior doesn’t get as much discussion as it deserves. Perhaps that’s because it isn’t easy to describe customer behavior in a formula like economies of scale or network effects. Many times, customer behavior is explained by psychology. Again, a checklist is a powerful tool.

For example, looking at frequency and purchase price is helpful. High frequency with low purchase price is good. Customers are rational only when they first choose a product. Once they are satisfied with their choice, they’ll be loyal. They don’t want to think and choose every time they buy the product. They rely on habit instead. That’s why consumer products are such a good business.

Low frequency with high purchase price is bad. Customers are rational. They spend a lot of time to compare alternatives. That’s why I think selling to business customers is difficult. That’s why I don’t like consumer electronics companies.

Low frequency makes auto part retailers like AutoZone (AZO) a good business. Customers don’t buy often so they don’t know much about price. Auto part retailers don’t compete on price. They compete on service instead. AutoZone focuses on “Yes rate”.  AutoZone doesn’t want to say No to customers. It wants customers to know that AutoZone will solve their problems. So, frequency is low but the awareness is high.

On the contrary, low frequency makes fine dining restaurants like Ark Restaurants (ARKR) a difficult business. Customers go to these restaurants on special occasions. There might be a lot of planning. Customers may not be loyal. But once the service is bad, customers will never come back. So, despite the crisis and rising food cost, Ark couldn’t reduce payroll. They must maintain good service.

Among my 10 points, I didn’t find much discussion about product economics in books. But it’s very important. Strong competitive position with bad product economics is bad. Railroads has strong moat but bad product economics. They earn only an adequate return on investment.

So, it’s important to see whether costs are fixed or variable; whether the business requires a lot of capital investment; whether growth requires much capital; whether the product cycle is long or short; or whether cash collection is faster than cash payment; etc. The list of questions just keeps expanding as I gain more experience.

I Didn’t Get More Information, My Eyes Just Get Keener

As I mentioned above, the information I look at didn’t change. I read all conventional sources. I read 10-Ks, transcripts, and interviews. I try to read all books about a company. I read all articles I can find about a company. I read from the oldest to the most recent article. That helps me see how the company evolved over time.

I do the same thing to customers and competitors. So, it’s a good idea to analyze end-customer and go up the value chain.

I look at data and information with my checklist (and sub-checklist) in mind. I make notes or do calculation with data whenever I see something relevant. I update my checklist after each research. And I’ll reduce the amount of important information I miss in later research.

Discussion off

QLogic (QLGC)

by Geoff Gannon

Two people I know have brought up the same stock idea to me: QLogic (QLGC). Someone I email back and forth with brought it up as an example of a company that has been a constant buyer of its own shares. And now The Graham Disciple has written about QLogic. His focus is on the balance sheet.

Discussion off

Berkshire Buys Back $1.2 Billion of its Own Stock

by Geoff Gannon

Warren Buffett's Berkshire Hathaway (BRK.B) put out a press release announcing it bought back over $1.2 billion of its own stock. Berkshire also announced it will pay up to 120% of book value for its stock. Previously, Berkshire had been willing to pay 110% of book value.

Talk to Geoff about Berkshire's Buyback

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Warren Buffett's Berkshire Hathaway (BRK.B) put out a press release announcing it bought back over $1.2 billion of its own stock. Berkshire also announced it will pay up to 120% of book value for its stock. Previously, Berkshire had been willing to pay 110% of book value.

Discussion off

Capital Allocation Discounts

by Geoff Gannon

Value and Opportunity has an excellent post on holding company discounts. The key point of the post is the division of holding companies into 3 types: value adding, value neutral, and value destroying.

Excellent point. I would take it a step further. The issue with the discount that should or shouldn’t be applied to holding companies is capital allocation. Capital allocation has a huge influence on long term returns in a stock.

But not just holding company stocks. All stocks. A company that buys back stock when it’s cheap deserves to trade at a premium to other stocks. A company that issues stock when it’s cheap deserves to trade at a discount.

I recently looked at a list of good, cheap U.K. businesses. I passed on most of them. Not because they were too expensive. Most were cheaper than similar quality U.S. companies. I passed on the U.K. companies because they tended to issue shares over the last 10 years.

Some of these U.K. share issuers traded around enterprise values of 6 times EBITDA for much of the last decade. Interest rates were not high during the last 10 years. Issuing stock at 6 times EBITDA is criminal. I don’t care what you were acquiring. You can’t make money doing it by issuing such cheap currency.

Capital allocation at non-holding companies is critical. And often overlooked. Because it’s complicated. Take Western Union (WU). Western Union made several acquisitions over the last few years. They overpaid.

That’s the bad news. The good news is that Western Union never stopped buying back its stock. And when they needed money – they borrowed. They didn’t issue stock.

Let’s take a look at CEC Entertainment (CEC). This is Chuck E. Cheese. The stock has returned 8% a year over the last 15 years – versus 4% for the S&P 500. That’s impressive for 2 reasons. For most of the last 15 years, Chuck E. Cheese’s operations have been getting worse – not better. Margins have dropped virtually every year for the last decade. And the stock is cheap right now. EV/EBITDA is about 5. It’s hard for any stock that cheap to show good past returns – an incredibly low end point is incredibly hard to overcome.

I doubt anyone is applauding CEC’s board. But they should be. It would’ve been very easy to deliver returns of zero percent a year over the last 15 years.

Operating income peaked 8 years ago. Earnings per share kept rising for the next 7 years. Shares outstanding decreased 57% over the last 10 years. Those are Teledyne like number.

Some might argue the return on those buybacks has been poor. And they would have been better off paying out dividends. Maybe. But let’s consider another alternative – the one most companies actually take. CEC could’ve invested that cash – not in buybacks or dividends – but in expanding the business.

Investors make an arbitrary distinction between operating companies and holding companies. They blame CEC for bad operations. And don’t applaud them for good capital allocation. The truth is that your return in a stock is the product of both those factors – how operations are managed and how capital is allocated.

There should be a discount applied to many conglomerates, holding companies, etc. But it has nothing to do with their structure. I apply a discount to most large tech companies based on the dumb acquisitions they will make in the future.

Should you apply a discount to Google (GOOG) the corporation that you wouldn’t apply to Google the search engine?

I think so. I’d be willing to pay more for outright ownership of the search engine if I could allocate the free cash flow it generates. The rest of the company is likely to be value destructive.

Finally, I would caution every long term investor about assuming standard discounts for holding companies, conglomerates, etc. Historically, there is no such thing. It’s a matter of taste.

A half century ago, there was a conglomerate premium. In the early part of the 20th century, some insurance companies traded at discounts to book value simply because they were valued on the dividends they paid. If you didn’t pay big dividends and you were a bank, insurer, etc. – it didn’t matter how much book value you had – Wall Street marked you down. Financials were supposed to be priced on yield.

This leads to a related issue. And it’s a big one for modern investors. Can we drop “dividend yield” from our lexicon.

When most companies didn’t use buybacks the idea of a dividend yield had some validity. When companies followed unorthodox capital allocation policies – it was a poor measure. But for companies following the accepted payout policies, it made sense.

Does dividend yield make any sense today? Some companies pay dividends. Some companies buy back stock. Some companies do both.

Why is it that when I type in a ticker symbol I’m immediately shown the dividend yield? And there’s no mention of stock buybacks?

Because of tradition. That’s the only reason. It’s become customary to show the P/E ratio and dividend yield for a stock. Neither measure is as important as its prominence on stock websites suggests. But tradition says it belongs there.

I want investors to think for themselves when it comes to things like holding companies. A standard discount is just a tradition. In the 1960s, conglomerates traded at a premium, stocks paid dividends, and men wore hats.

Those were historical facts. Not immutable laws.

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Relativity and Anchoring

by Quan Hoang

Recently I read . The book talks about human irrationalities. It’s a great business related psychology book. I found two ideas relevant to why I like companies with unique products. The two ideas are about relativity and anchoring.

We Always See Things in Relation with Others

The human brain is not equipped with a meter that measures absolute value. So we usually rely on relativity. We look at things around and compare. The picture below demonstrates this idea:

The two middle circles are the same size. But the one surrounded by bigger circles looks smaller than the one surrounded by smaller circles. We have no idea how big a circle is. We just look around and compare.

My personal example is when I looked for a phone recently. I just need a phone to make calls and send messages. I don’t need a smartphone. So, I used a simple, old phone for many years. But recently it broke. I decided to buy a smartphone.

I found a used Google Nexus One on Amazon. It’s in very good condition sold by a highly rated seller. It costs only $100. I was totally impressed with its design at first sight. The specs look great for my need.

But it took me several hours to make a decision. That’s because I compared it with other phones. A bigger screen would be better. A strong battery would be useful. A Quad-core processor is definitely more powerful. Jelly Bean looks cooler than Gingerbread.

Considering my need, I don’t think those phones are different. But I still compared and had the urge to buy the best phone. Finally, I chose Google Nexus One. (I’m quite a rational buyer!) I’m totally satisfied with it although it seems obsolete compared with other phones.

My point is that we always look at things around us in relation with others.

We Rely on an Arbitrary Anchor

Beside relativity, people’s views on things are usually influenced by some anchors. When it comes to price, we don’t know the value. So we tend to rely on some arbitrary benchmark.

One example would be bargaining. In Vietnam, we always bargain when shopping. If the listed price is $50, I would propose $30. If the listed price is $30, I would like to pay $20. I have no idea about value. I just know that it’s worth less than the listed price.

The U.S. version of this example would be a sale. Most people want to buy clothes at 40-50% off the sticker price. They feel they overpay when they pay the full sticker price. I think there are two anchors here. The first anchor is the sticker price. The second is the percent discount we usually get.

Customers Won’t Know If a Product is Expensive without Comparison

We usually use both comparison and an anchor to value something. We look at relative value between things and base our estimates on some basic anchors

I think anchoring causes some misconception about Western Union (WU). When Geoff asked me to analyze WU, my quick answer was “it might be too hard, the service is expensive, and there can be a lot of changes.” But after I looked deeper, I realized it’s not as hard as I thought. The service is not expensive like most people think. Why did I think it’s expensive?

That’s because I always use PayPal to do money transfer with friends. It’s free when I link my PayPal account to my bank account. My experience with PayPal makes me think a money transfer fee should be close to 0%.

It’s different from the perspective of customers. I talked to my cousin who went to work in Taiwan. He uses Western Union to send money home every month. He’s highly satisfied with the service. Customers only think a product is expensive when there’s a much cheaper alternative. Western Union has a small price premium over competitors, but they keep the price competitive. And PayPal is not cheap. PayPal International transfer from bank accounts costs 0.3-3.3% fee and currency conversion. It costs over 3.4% to send from debit card/credit card.

Demand Can Be Manipulated

The idea about anchoring raises a problem in the fundamental rule of supply and demand. There are two curves. The supply curve tells how many units are available at each price. The demand curve tells how many units customers want to buy at each price. The intersection of the two curves indicates market price. The implication of the rule is that supply and demand are two independent forces. But the idea about anchoring says that demand can be easily manipulated by supply.

That’s why I think anchoring and relativity are relevant to the profitability of selling unique products. Companies with unique products can manipulate demand more easily.

Breaking Old Anchors by Being Unique

The example in the book is Starbucks (SBUK). We can be initially anchored to the price of coffee at Dunkin’ Donuts or drinking coffee at home. How did Starbucks break that anchor?

They make themselves unique through store ambience. For example, their shops are fragrant with the smell of roasted beans, which are of higher quality than those at Dunkin Donuts. They have fancy product names for size like Short, Tall, Grande, and Venti, or for coffee like Caffe Americano, Caffee Misto, Macchiato, and Frappuccino. The store experience is so different that the previous anchor is no longer relevant.

If you’re satisfied, you’ll go back to the store. Once you get used to spending $2.20 on a small cup, you may see $3.50 for a medium or $4.15 for a Venti as normal. That’s because you have an anchor price for a small cup. Paying some more for a bigger cup is normal.

I’m amazed at how Zara changes customer behaviors. They introduce thousands of designs every year. But they produce limited copies for each design. They usually sell out a design within 2 weeks. So, customers know that if they don’t buy, the item would be sold out quickly. And they know Zara rarely offers sale. With little time to look for alternatives to these unique items, customers tend to buy immediately (at full price!).

Price is Usually Determined by an Established Anchor

Sometime, price is determined by an established anchor. That’s common in content business. Products are unique, and companies don’t compete on price. If people like a product, they’ll pay a common price. That’s why movies don’t compete on price at movie theaters. That’s why a video game usually costs $40-$60.

The established anchor can also be changed. That’s my concern with Nintendo (NTDOY). They make casual games, not hard-core games like Call of Duty. With the rise of mobile games, people may get used to a new price range for casual games. It’s a big problem for Nintendo if the anchor their games are compared to drops from $40 to $2.

A Good Anchor Improves Perceived Value

Anchoring explains the retail strategy for fashion brands. Companies want to anchor the value of their products as high as possible. Prada wants to open stores next to Gucci. Gucci wants to be next to Prada. They both want to keep themselves far away from Zara while Zara want to be as close to them as possible.

The similar example in Predictably Irrational is when James Assael, the king of pearl, introduced Tahitian black pearls. He bought advertisements in the glossiest of magazines, which put Tahitian black pearls among diamonds, rubies, and emeralds.

On the contrary, I think it’s a stupid idea for Hulu to hope to convert free service customers into using pay service. They anchor customers with a free service. That’s a very hard anchor to break.

The value of free is astronomical. Amazon (AMZN) was able to boost sale when they offer free shipping for order over $25. That’s because customers may want to buy unnecessary books just to get free shipping. But when they offer 10 cent shipping for order over $25, sale didn’t improve at all. So, I would guess the free anchor is very hard to break.

It’s different from giving a free trial. Giving a free trial is a great idea. It doesn’t create an anchor. It actually helps to increase perception value thanks to value of ownership. Basically, when you own something, you value it more. We tend to value things that we own by fear of loss. Customers after the free trial period may value the service more and are more likely to subscribe.

Uniqueness Can Result in Pricing Power

Companies with unique products may also have pricing power. When the products are not anchored to any price, the company can have more freedom to increase price. It’s harder when there are comparable products or substitutes.

That’s why I prefer Games Workshop to giant Mattel (MAT) or Hasbro (HAS).

Hasbro and Mattel produce toys for the mass market. Their pricing power is limited. Each toy is unique but it’s still a toy. Toys as a category have to compete with other entertainment products. The price of other products is out of Hasbro’s and Mattel’s control. And people can compare those products with toys.

Also, there’s an anchor for toy prices. The price sweet spot is from $10 to $20. Hasbro saw volume decline when they increased price from $19.99 to $21.99. I think this has something to do with the way people buy toys. Parents and grandparents usually buy toys on holiday. They tend to buy several gifts at a time. A family with 2 kids may want to buy 5 toys. They have a budget for toys because they also buy gifts for their spouse or friends. So, they may not want to spend over $20 for a toy.

Games Workshop is another story. Those unfamiliar with Games Workshop should read the discussion about the company at Interactive Investor. Games Workshops produces hobby products instead of toys. People are willing to spend a lot of money on a hobby. I don’t think that people dedicate time and money to more than one hobby. Even if they do, Warhammer is cheaper than most hobbies. By positioning Warhammer as a hobby, Games Workshop aligns pieces of plastic with hobby products like golf clubs. People don’t value a hobby product by how much it costs to produce. They value it by the enjoyment they get. So, Game Workshop increases price every June. Hobbyists complain but they still buy and enjoy.

So, I think relativity and anchoring are powerful ideas in learning customer behaviors. I think companies with unique products can have pricing power thanks to the lack of comparison and price anchor. They can also improve value perception by getting closer to other high value unique products. And when there’s no comparison, companies just need to maximize the price they can sell, and make sure that customers enjoy the products.

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